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The Unbundling and Rebundling of Software

The business of software is about much more than licensing. Software vendors deliver many kinds of ancillary value around the software itself. Increasingly, innovation in the software industry comes from unbundling these elements of value, and rebundling them in new combinations.

Some Context

Historically, software has been structured as a licensing business. This goes back at least to the early days of PC software when the primary means of distribution was though software publishers, reflecting the traditional practices of the book industry. Publishers distributed the software product, and provided end-user support, while paying a royalty to the software authors. (For a real life story of how the economics of software worked in this early PC era, check out the chapter on Mitchell Kapor and the early days of Lotus in Jessica Livingston’s excellent Founders at Work.)

This licensing paradigm for software has evolved in a few ways since then, but in general has remained fairly consistent for the past 30 years. This is especially true in the world of enterprise software (that is, software bought by companies and managed by IT professionals).

At long last, however, change has come to enterprise software in the form of unbundling and rebundling.

The Software License Model

In the typical enterprise software licensing business model, the customer pays for several distinct line items:

A license to use the software (either forever, a “perpetual license”, or for a limited period, a “term license”)

Ongoing maintenance, support, and updates (often costing something like 10% of the initial license, per year, as long as support is provided)

Professional services, which is enterprise software jargon for the consulting required to install and configure the software, and train the customer on its use.

The "bundle" of value can be summarized at a high level by this diagram:

This may be the dominant model for enterprise software, but it suffers from multiple deficiencies.

First, cash flows are lumpy and detached from the realization of value by the customer. For the customer, this means they wind up laying out significant cash up-front, on the promise of theoretical value to be delivered some day down the road.

Second, the software vendor lives a high stakes game of brinksmanship with the calendar, trying to manage unpredictable sales events to meet the expectations of investors and to fund the business. This is the domain of high-pressure salespeople working the phones and deeply discounting to “make the quarter." Anyone who has purchased software from Oracle has been on the receiving end of this phenomenon, and the even more problematic hold-up problem around renewals.

Finally, and perhaps most importantly, the customer typically takes on significant responsibility for deployment, management, and operations of the software. While it’s not a line-item on the bill from the software vendor, this additional cost is very real and hits the bottom line in the form of spending on underlying infrastructure (servers, networking, power and cooling) and the salaries for the additional headcount required to feed and care for all of this computer administrative debris. That’s not to mention the opportunity cost of having highly compensated staff focused on menial software tending tasks when they could be doing something more valuable for the business.

The SaaS Subscription Model

As an alternative to the software license model, let’s consider the software-as-a-service (SaaS) subscription model, which has emerged in the last 15 years, led by companies like Salesforce.com.

In a SaaS subscription business model, the vendor takes responsibility for the ongoing operation and administration of the software. Infrastructure costs, such as datacenter resources, management, and upgrades are incorporated into a simple subscription pricing regime.

In our terminology of unbundling and rebundling, software-as-a-service adds infrastructure and ongoing operations to the bundle. The subscription model then provides a smooth set of cash flows for the complete bundle, making it easier for customers to reason about the total cost associated with a new software project.

By extending the traditional software license bundle, the SaaS subscription model addresses several deficiencies of the software license model.

First, from the customer’s point of view, cash flows are now tied more directly to the realization of value. Because there are no up-front fixed costs, customers can start small, experimenting with new products and services first, and then scaling up usage as they are proven.

Second, the vendor also benefits from more predictable cash flows. As customers ramp up their use of the software, revenues scale accordingly, without the constant need for acts of heroic salesmanship. The SaaS subscription model also naturally opens up new dimensions for pricing the service, for example by the amount of data under management, number of transactions processed, or number of applications in use. None of this needs to be pre-committed in advance, reducing the risk all around. (It’s worth noting that the subscription model also requires more capital investment up front due to the delayed cash flow, but at some level that is a matter of financial engineering and the venture capital community has demonstrated a strong willingness to fund high-growth SaaS subscription businesses.)

The Open Source Subscription Model

Subscriptions for open source software represent another re-bundling of the traditional software license model. Pioneeered by Red Hat, open source subscriptions are the principal business model of companies like Cloudera, MongoDB, and Typesafe.

With the typical open source subscription model, the license to acquire and use the software itself is free of charge, and the subscription bundle captures the remaining elements of value, namely ongoing updates, maintenance, support, add-on products, legal indemnification, compatibility certifications, and more. (Note that it's about more than the popular misconception of "just support and consulting.")

In exchange for giving away one element of the software bundle — the license to acquire and use — companies adopting open source can gain amazing new distribution possibilities and positive externalities from users co-developing the software and extending it at the margins.

The open source subscription model also partially addresses the hold-up problem discussed earlier. As was frequently remarked at Red Hat in the early days of the subscription model, with open source “every year is an election year." In practice, open source subscriptions have proven to have a high stickiness (measured by renewal rate), but this is the result of value delivered rather than the threat of losing the rights to use the software.

Emerging Models

Even as software-as-a-service and open source increase grow in popularity, new models are emerging that mix and match the elements of the software value bundle in new ways.

For example, platform-as-a-service (PaaS) starts with the software-as-a-service model and then removes the application software from the bundle, leaving a managed, supported infrastructure for developers. Heroku, Cloud Foundry, and OpenShift are examples in this category.

Infrastructure-as-a-service (IaaS) removes another layer from the bundle, stripping the application from the mix and providing raw compute resources and operations capabilities. Amazon Web Services and various embodiments of OpenStack lead the pack here.

A more novel example of rebundling is the emergence of marketplace models in enterprise IT. Several marketplace businesses remove traditional professional services or support from the bundle, and replace it with a crowd-sourced capability. Emerging examples include Applause for application testing and Synack for security validation.

Opportunity

The great unbundling and rebundling of software is underway. This is a moment of peril for incumbent software vendors, but also an incredible opportunity for entrepreneurs who have the perspective to see where the software industry has been, and to imagine where it may be going.